Master programme in Economic History
The Euro, Theoretical Expectation versus Economic Reality?
Jonathan Pike
Abstract:The euro was launched to great fanfare as a physical currency in 2002 but the very idea of European Economic & Monetary Union (EMU) was and continues to be a controversial and hotly debated topic. Nine years since that date, this paper revisits the debate that took place in the lead up to the Euro and the theoretical benefits and costs that were highlighted at that time. It aims to critically analyse the track record of the single currency to see whether such costs and benefits have been borne out in the historical record. The paper argues that the Euro has failed to have the large trade and price convergence effects that were theorised. In contrast, many of the theoretical costs that were pointed to can be seen in the Euro’s history as the European Central Bank followed a monetary policy that definitively failed to suit all its different members and the currency has been a source of asymmetric shocks and trends. With previously booming periphery countries facing huge debt problems and deflationary pain, the EMU project stands at the crossroads. This paper finds that although a break up is very unlikely, steps must be taken to make the project work more optimally.
Key words: Euro, Eurozone, Economic & Monetary Union
EKHR11
Master thesis (15 credits ECTS)
June 2011
Supervisor: Lennart Schön
Examiner: Jonas Ljungberg
Contents
1. Introduction:
2.1. The OCA theory:
2.2. OCA and the Eurozone:
3. Theoretical Benefits of the Euro:
3.1. Full EMU will increase trade:
3.2. The promise of price transparency
3.3. The Euro will help decrease Asymmetric shocks:
3.4. Inflation discipline and Commitment Gains from it:
4. Theoretical Costs of the Euro:
4.1. One size does not fit all:
4.2. The Euro and asymmetric shocks:
4.3. Lack of adjustment mechanism to asymmetric shocks
4.4. Loss of devaluation as an instrument of economic policy:
5. The Euro and the historical record:
5.1. Has EMU increased trade?
5.2. Has EMU brought price transparency?
5. 3. ECBs Inflation performance and ‘One size does not fit all’:
5.4. The Euro, asymmetric shocks and divergences:
5.5. Lack of adjustment mechanism to asymmetric shocks:
5.6. Loss of devaluation and the debt issue:
5.7. Unpopularity of the single currency:
6. The Future of EMU:
6.1. The Breakup of the Euro Area?
6.2. Redressing Eurozone fragility
7. Conclusion:
1. Introduction:
The objective of this paper is to analyse the Euro, otherwise known as EMU (Economic and Monetary Union) to see whether the theoretical costs and benefits highlighted in the lead up to the inception of the currency have been borne out by the historical record. One can argue that over 12 years after the Euro was first introduced to financial markets and 9 since its physical introduction sufficient time has passed with the common currency to pass judgement on it. Furthermore, the fact that the Euro seems to be in trouble, with some questioning its very existence, due to the instability on its periphery, the timing of this study is particularly pertinent.
The paper develops as follows. Before turning to the core issues, the Optimal Currency Area (OCA) theory, a pioneering work on the costs and benefits monetary unions, is reviewedand its role in the setting up of the Euro’s institutional and policy framework examined. It is argued that the theory was largely ignored and instead of focusing on the factor mobility that was at the OCA’s heart, the Maastricht treaty instead focused on nominal convergence.
The third section outlines the theoretical benefits that were expected from the single currency. Firstly it was argued that through the elimination of transaction costs and exchange rate uncertainty, the Euro would increase intra European trade. Although the European Commission itself did not attempt to quantify such an increase, one paper in particular seen as a key study at the time, argued that the trade gains would be very large indeed. Secondly, through greater price transparency and the ‘law of one price’ a narrowing of intra Euro member price differentials was expected. Thirdly, there was evidence at the time that European business cycles were becoming more synchronized and this was a process that some argued would continue with the single currency with even greater trade integration. This would reduce the chance of asymmetric shocks which affect some members more than others and it was hoped that the EMU’s fiscal framework wouldcontribute to Euro macroeconomic stability. Furthermore, it was argued that by anchoring to a credible monetary authority, the European Central Bank and countries with a low inflation record, member states with historically high inflation would have commitment gains brought by inflation discipline.
The fourth section highlights the key theoretical costs that were outlined in the lead up to EMU. Firstly, it was argued that due to business cycle differentials, with one country or group of country growing faster than others, the ECB would have a ‘one size does not fit all’ problem in the conduct of its monetary policy. Linked to this was the so called ‘Walters Critique’ which argued that common monetary policy would be more expansionary in countries with high inflation rates and contractionary in countries with low ones. Secondly, it was argued that in the absence of political union that the Euro may actually be a source of asymmetric shocks through member states own budgetary policies. Moreover, in the event of an asymmetric shock with diverging economic growth within the Eurozone, it was contended that Europe lacked the institutional and labour market flexibility, creating an adjustment problem. Lastly, some bemoaned the loss of the devaluation policy option although this was seen as a benefit to others.
The fifth section weighs such theoretical considerations against the historical record. It is argued that the theoretical benefits have largely failed to materialise whilst the costs have been borne out. For, predictions of large increases in trade were found to be wide of the mark and although some studies have found the Euro to be the source of substantial trade increases, these studies have been criticised for their methodological weakness, for example by not taking into account the effect of the single market over time. Secondly, and generally accepted by the literature, is that the Euro has not brought in a spate of price convergence. Although there may be many reasons for this development, it does not change the fact that a promised benefit has not happened.
Also, one can argue that the ECB’s monetary policy did not fit all as periphery PIGS (Portugal, Ireland, GreeceSpain) nations overheated and others such as France and Germany experienced slow growth. The looser than optimal ECB monetary policy contributed to the periphery’s boom and the reality of the ‘Walters critique’ can be seen in the asset price bubble of such nations. Furthermore, boosted by tax revenues from such a bubble the PIGS countries engaged in a public spending spree that the EMU’s fiscal framework allowed. Large-scale wage increases and a loss of competitiveness were the result. Such profligacy can be seen to have been a source of asymmetric shocks as when the bubble burst these countries faced a debt crisis and many have had to be bailed out by the European Union and International Monetary Fund. The lack of labour mobility can also clearly be seen in the Eurozone today as unemployment is stubbornly high in the periphery and falling in Germany for example. Moreover, with the lack of the devaluation tool and unable to issue debt in their own currency, these countries are finding it hard to repay their debts and restore competitiveness. With the Eurozone in such a state it is no surprise that the single currency’s approval ratings have declined.
This state has led some to openly contemplate the prospect of a Euro breakup. However, although a country determined to leave EMU could probably do so, section 6 argues that the legal and technical barriers are huge and would be incredibly costly to overcome. EMU is indeed irreversible. Therefore, it is better to focus on ways that the Eurozone can function more optimally. Section 7 argues that a fully fledged fiscal union with automatic fiscal transfers between member states would be the best way of solving Eurozone fragility but that this looks politically impossible. Nonetheless, there are other more realistic steps that could be taken. A more permanent financial support mechanism is a step in the right direction but it is not in itself enough to offset the effects of the asymmetric trend development in recent years. National fiscal councils can play a constructive role in tempering fiscal profligacy and a joint issue of Eurobonds would help a country against a future debt crisis and bad equilibrium. Also, although linguistic and cultural barriers to labour mobility are likely to remain high, opening up labour markets by making them more flexible may nonetheless help alleviate unemployment in stagnant regions. Lastly, the ECB should allow Greece and potentially others to restructure debt as this will help the Eurozone’s stability in the long term. It remains to be seen whether European leaders can agree on such sensible proposals but the clock is ticking.
2.1. The OCA theory:
Mundell’s 1961 OCA (Optimal Currency Area) theory has had a central role in monetary union debate andtoday, as in the past, a lot of the work on multinational currencies and their economic pros and cons are based on the theory. As such pro’s and con’s are evaluated extensively in this paper, it is worth outlining the key logic of such a theory and also its role in the creation of EMU.
The central question asked by Mundell in his theory is whether countries should ‘allow each national currency to fluctuate, or would a single currency be preferable’[1] despite losing two out of the three basic macroeconomic policy tools in the form of monetary autonomy and the exchange rate.
The answer Mundell gives is that such a common currency area will be desirable if certain conditions are met. Firstly, it will be preferable if all members of the union face common symmetric shocks that treat them equally and if asymmetric shocks that affect one or few members more than the rest are limited in both time and duration. Secondly, if countries in the union feature high co-movement of economic variables vis a vis each other and thirdly if there is high factor mobility, particularly labour, that is flexible at the micro level. Mundell (1961) saw gains in the form of increased trade due to less transaction costs and increased transparency and comparability of costs and prices. Nonetheless, if countries face dominating asymmetric shocks and the factor mobility between member states is poor, they should likely preserve their own currency.
Mundell later updated his OCA work in 1973 with the argument that the loss of the exchange rate as a policy tool should not be considered a drawback as ‘it was no longer considered an affective tool for adjustment, as the central bank should be concentrating on price stability and not trying to fight market forces’[2]. For, the exchange rate, rather than an important policy tool had in itself become an important source of asymmetric shocks. Furthermore, by eliminating such exchange rate risk this increases cross national asset diversification which ‘mitigates the impact of asymmetric shocks on the single country, making the desire for country’s individual monetary and exchange rate policies less pressing’[3].
However, despite this modification, it is still Mundell’s original theory which economists usually measure any currency union against and as De Grauwe (2006) notes ‘as some Euro countries have suffered competitiveness losses since the introduction of the new currency, Mundell’s 1963 ideas are coming back into fashion’[4].
2.2. OCA and the Eurozone:
As Wyplosz (2006) has argued ‘the view that exchange rate volatility is harmful to trade integration has been a mainstay of European official thinking ever since the 1940’s’[5]. Since that time there were, therefore, several attempts to fix such exchange rates within certain bands to reduce such volatility, most notably with the 1972 ‘Snake’ system and the launch of the European Monetary System in March 1979. Nonetheless, it was not until the late 1980s with the collapse of the Soviet Union, the declining US role in the European continent and likely German Unification that a new impetus was created for the further deepening of European political and economic integration. France extracted German commitment to future monetary union in exchange for such unification and backed by the continents two powerhouses, the result was the so called Maastricht treaty which formally established the concept and basic characteristics of Economic and Monetary Union (EMU).It is therefore useful to see how the treaty dealt with the OCA theory.
In practice, it paid scant attention to it. In the European Commission report ‘One Market, One Money’, outlining justification for monetary union, it argued ‘the OCA approach provides useful insights but cannot be considered a comprehensive framework in which the costs and benefits of EMU can be analysed’[6]. Indeed, as Sapir (2009) has shown, ‘whereas OCA emphasises real convergence among the candidate countries to monetary union, Maastricht instead insists on nominal convergence’[7] and to this end focused on inflation, exchange rates, interest rates and public finance rather than possible asymmetric shocks due to structural differences. Wyplosz (2006) argues that the overlooking of output and employment stability, at the heart of OCA theory was ‘arguably the monetary union’s original sin’[8].
Ignoring the OCA theory was likely due to a number of factors, chiefly because macroeconomic shocks were seen as less likely in a monetary union and, as demonstrated later in this paper, there was an expectation that a single currency would promote greater business cycle symmetry. However, one must also take into account, as Rusek (2008) has contended, that ‘it is necessary to recognise that the Euro and its existence today is much more the result of the political will to advance European integration than the economic logic’[9]. Nonetheless, it is useful to carry out an economic cost benefit analysis as ‘it gives an idea of the price some countries will have to pay to achieve these political objectives’[10]. For, the Euro was launched virtually to great fanfare in 1999 and it was hoped it would generate large economic gains for member countries. However, sceptics were unsure of this and instead pointed to imbalances and future asymmetric shocks. An in depth analysis of such a debate is now looked at.
3. Theoretical Benefits of the Euro:
3.1. Full EMU will increase trade:
One of the main benefits expected from the creation of monetary union was an increase in trade among member states of such a union. Mundell (2002) argued that ‘the basic gains from currency unification in the international sphere stem from the extension of national free trade areas to a wider unit. The larger the common currency area, the greater will be the gains from trade and lending’[11]. The two mechanisms that were pointed to through which monetary union could do this were fewer transaction costs and less exchange rate uncertainty. In terms of the former, transaction costs are effectively those incurred when exchanging one currency into another and is one of the most visible gains from any monetary union. Such costs are as De Grauwe (1998) demonstrated ‘a deadweight loss in that they are like a tax paid by the consumer in exchange for which he gets nothing’[12]. Although, savings from such costs were expected to be in the low range, around 1% of EU Gross Domestic Product (GDP) according to the European Commission (1990), it was argued that ‘since the reduction in transaction costs should stimulate intra-EU trade, the overall savings in transaction costs could actually be larger than 1% of GDP’[13].
In terms of the effect of exchange rate variability and its effect on trade, there was not an academic consensus on such effects in the period leading up to the Euro. For, ‘exchange rate volatility will, in fact, increase average profits under standard assumptions about profit functions and should therefore serve to increase trade’[14]. However, a theoretical approach that Euro enthusiasts pointed to was to see trade decisions along the framework of the option theory of investment developed by Majd and Pindyck (1987)[15]. For, a decision to start exporting or importing will involve investment costs, such as market research and marketing and perhaps building new production capacity, costs that are only partly reversible and take place over a time period. A firm may put off expanding trade due to the positive option relating to this as the exchange rate may become more favourable, making the investment more profitable. The firm may also wait as the exchange rate becomes unfavourable in which case the investment can become unprofitable and should not be undertaken. The value of the option to wait increases with the degree of uncertainty, in other words the volatility of the exchange rate. This led some, such as Flam & Jansson (2000) to conclude that ‘uncertainty in exchange rates therefore represent an important cost element in any decision to start exporting, importing or investing in a foreign country’[16]. Monetary union would eliminate such a cost element.